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September 12, 2013

Who Gets the Beach House? A How-To for Advisors on Helping a Family Decide

Merrill Lynch lays out the realities of how to help a multigenerational family create a trust that covers capital improvements, maintenance and taxes

Beach houses are often perceived as the pinnacle of achievement for a high-net-worth family. Like the Bush or Kennedy family compounds in New England, they evoke thoughts of multigenerational ties and shared values, songs by the campfire and touch football on the lawn.

And then there’s the reality.

When Stacy Allred, a director in the wealth structuring unit of Merrill Lynch’s Private Banking and Investment Group, sat down to work with a West Coast family on preserving their cherished gathering spot along with a sense of multigenerational harmony, she quickly found herself dealing with a challenge that has cropped up for many baby boomers and their children. While a beach house, mountain retreat or European villa may be just a vacation home, it is also charged with emotions and family history that must be considered when the time comes for the next generation to take possession of that beloved second home.

A Small Cabin Becomes a Large House

In the case of Allred’s clients, a young couple living in San Francisco back in the 1960s bought a small cabin on a large piece of land on the coast, two hours from the city. What was at first a getaway for the young couple and their four small children became a place that the whole extended family enjoyed, including aunts, uncles and cousins. A series of renovations and additions turned the small cabin into a large house, and those four children now have adult children of their own.

“The original matriarch and patriarch have died, and the trust they left for upkeep and maintenance is dwindling,” recounts a Merrill viewpoint, “Who Gets the Beach House?,” published this August, just as many families were enjoying their final summer days on the shore. “After years of exposure to the elements, the home needs a new roof, new siding and other major repairs. Yet those physical upgrades, while significant, are merely symbolic of much larger challenges facing a family that longed for the home to be as meaningful for subsequent generations as it had been for them. Who pays the bills? Who oversees the upkeep? Who gets to use the house, and when?”

For the Northern California family, one son had done particularly well financially. While it might seem that his good fortune solved the family’s beach house preservation issues, it was only the beginning of a process that involved a meeting of siblings and their spouses plus nieces and nephews, featuring Allred as mediator.

“They didn’t want to come in as ‘deep pockets,’” Allred recalls of the son and his wife, who had asked her to help organize and run the meeting. “They wanted it to be collaborative. The biggest priority was maintaining family unity. They didn’t expect preferential weeks in the home, or an extra vote on matters pertaining to the house.”

For advisors who need to help their own clients resolve beach house estate planning issues, read on for a how-to from Merrill Lynch’s Private Banking and Investment Group.

Working with the northern California couple’s certified public accountant and estate attorney, Stacy Allred of Merrill Lynch’s Private Banking and Investment Group helped coordinate a strategy to create a trust to cover major capital improvements, ongoing maintenance and taxes for the family beach house.

The technicalities of the transaction look like this: The trust was structured to receive gifts as “current” gifts, meaning that the recipients had the right to withdraw the gifts from the trust within a limited window and use them for their own purposes. Thus, the couple was able to use their annual gift tax exclusion to fund the trust without having to cut into their lifetime gift tax exemption limit. This is because the government allows each spouse annual tax-exempt gifts of up to $14,000 per individual recipient, so the brother and his wife together were able to give a total of $28,000 to each of 18 relatives, for a total of $500,000. The couple can repeat this process each year until the trust has reached a level capable of maintaining the home for decades to come.

While every family situation is unique, the case of the California compound highlights “a universal point about the intergenerational issues surrounding the family vacation home,” according to the Merrill publication. “They should be handled with the same attention to detail you’d bestow on the succession of a family business.”

The Essential Master Plan

Michael Liersch, director of behavioral finance for Bank of America Merrill Lynch, acknowledges that such a view may seem counterintuitive, since a family retreat is supposed to be about feeling good and letting go. “People tend to think that a place of relaxation and fun is a place without rules,” Liersch says. “But a place of anxiety and uncertainty isn’t fun, and that’s what having no rules creates.”

Liersch advises creating a “master plan” that includes an online calendar that extended family members spread across the country or around the world can access through a file-sharing application. “That way people can request times for the home, and everyone knows who’s using the place and when,” he says. “The calendar can include maintenance schedules and track routine expenses.”

To be sure, the master plan’s arguably most vital function is a clear directive on how the property will transfer from one generation to the next.

“The facilitator’s report provides sufficient information so that family members can make meaningful decisions with respect to the property jointly,” Goffe writes. “If the family is unable to reach an agreement, one or more family meetings guided by the facilitator could follow to resolve areas of dispute, further define areas of agreement, and continue building a consensus. The development of a master plan with the assistance of a trained neutral third party is especially useful when the senior generation has already ceded control of the property to the next generation and questions and issues concerning actual management have arisen.”

How to Hand a House Down

The most efficient way to hand the house down is through an outright gift while the owners are still alive, according to Merrill Lynch’s Private Banking and Investment Group. “It’s relatively easy, inexpensive and can require minimal paperwork,” the viewpoint asserts.

Potential tax benefits also make this an attractive option. While 22 states impose estate and/or inheritance taxes, only Connecticut and Minnesota have a gift tax. At the federal level, gift and estate taxes stand at 40% for amounts greater than $5.25 million as of 2013, adjusted annually for inflation.

“There is, however, an advantage to giving the gift during your lifetime,” the viewpoint adds. “It’s analogous to being able to invest pre-tax versus post-tax dollars into a retirement account: When you write a check to cover gift taxes, you can simply pay the amount out of whatever available resources you have. But if you leave the home in your estate and wish to have your estate cover the tax bill, you may be drawing on funds that have already been nearly halved by the wealth-transfer rate as part of your taxable estate.”

Ways to ease the tax burden of a vacation house include:

1) A qualified personal residence trust (QPRT). A QPRT with a term of 10 years, for example, the house is given to the trust, thus removing it from a taxable estate. During the term of the trust, the original owner continues to use the home and pay taxes and other regular expenses. Once the 10-year term expires, the beneficiaries become the owners of the property, and from then on, whenever the original owner uses the property, he or she must pay fair market rent.

There are drawbacks to a QPRT, however. If the grantor dies before the trust term expires, the home reverts to his or her taxable estate. And then, says the Merrill viewpoint, there’s the potential emotional drawback: “The former owner may find it irksome to pay fair market rent topping $15,000 a week for a Martha’s Vineyard or Sun Valley retreat that still psychologically feels like home.”

2) To retain greater control and protect against hurt feelings, families can instead transfer ownership of the home to a family limited liability company. The grantors then gift shares in the LLC to transfer ownership. There is a tax benefit to this method, as well. While distributed shares are subject to gift taxes, because multiple people have shares, individual recipients don’t control the property and can’t sell it, so the value of their gifts can be discounted for tax purposes.

“Unlike a QPRT, an LLC offers the flexibility to maintain or share decision-making responsibility as you see fit,” the viewpoint notes. “As with a family-owned business, you might, for example, decide to distribute nonvoting shares to the kids, giving them a financial stake in the house while withholding their vote in major decisions until you feel the time is right.”

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